Deutsche Bank warns proposed tax could hurt Europe's FX market

Tue Aug 6, 2013 3:20pm EDT

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Aug 6 (IFR) - A proposed European financial transaction tax of 0.01% on all derivatives transactions could bring foreign exchange markets in Europe to their knees, according to Deutsche Bank analysts.

The tax, which would also levy a 0.1% charge on share and bond trades, had originally been scheduled to launch on January 1 2014 before the 11 participating countries decided to delay implementation for a further six months after concerns it may be too harsh.

FX market participants will be hoping the FTT is scrapped altogether, with analysis from Deutsche Bank estimating it could cost the real economy billions of euros every year.

"In its current form, the FTT would have major adverse consequences for the FX markets," Oliver Harvey, macro strategist at Deutsche Bank, wrote in a report.

" could result in the effective closure of the non-spot FX market in participating member states."

Even though the FTT would exempt spot FX, it would still have an impact on FX derivatives that corporates, pensions funds, and insurance companies use to hedge their currency exposures, including swaps, options, forwards and non-deliverable forwards. These transactions account for nearly two-thirds of FX market activity, according to a 2010 survey by the Bank for International Settlements (BIS).

Those non-financial firms would probably bear the true cost of the tax, which would make financial intermediation for FX trades a cost-prohibitive exercise for banks. As and when the costs of the tax becomes too onerous, banks would most likely pull back from the market, reducing liquidity and widening bid-offer spreads.

A Deutsche Bank analysis of German export and BIS data estimated that the FTT would impose annual costs on German exporters and importers of up to 2.4 billion euros, while German exports could be reduced by as much as 3.3 billion euros per year.

"This proposal will have a substantial cost impact on corporates, given the way they currently hedge their FX risk," Deutsche Bank's Harvey told IFR.

"The tax would be passed on straight to non-financials, irrespective of whether they are exempt, because the spreads dealers pull from the trades are so much smaller than the tax itself."

UNIQUE FX STRUCTURE

There are a variety of factors explaining why FX market-making is especially vulnerable to an FTT. Currency markets maintain an extremely high velocity, with a total daily turnover in swaps and forwards markets alone of US$2.24 trillion - over seven times that of all global equity markets.

There is also the short-dated nature of the market: more than 40% of the FX forwards market is concentrated in tenors of one week or less, while for swaps it is 70%.

Shorter-dated swaps would be hit harder by the FTT than any longer-dated transactions. In a report last year, consultancy Oliver Wyman estimated the FTT would result in a 1,790% price increase for one-week euro-dollar swaps compared to a 270% increase for a six-month swap with the same underlying.

The price increases cited by Oliver Wyman actually equate to a rise in transaction costs corresponding to that witnessed during the Lehman Brothers liquidity crisis, according to DB analysis.

"FX swaps and forwards are rolled over on a daily or weekly basis by a wide range of market participants in order to meet a broad range of objectives," said Harvey. "These transactions would be hit each time by the tax."

ROADBLOCKS

Fortunately for FX traders, the FTT proposal has hit a series of snags since mid-April, when regulators began to throw up formidable roadblocks in the name of market efficiency.

First, the UK government launched a legal challenge to the tax at the European Court of Justice in an effort to curb the extra-territorial effect, since the British government chose not to participate in the tax but would still be required to collect when British firms transact in participating countries.

Then in June, the 11 participating countries decided to delay the planned implementation date, previously January 1 2014, by six months.

"To get to this tax we must be pragmatic and realistic," French Finance Minister Pierre Moscovici said last month. "The European Commission's proposal seems to me to be excessive and risks being counterproductive."

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